Central Electricity Regulatory Commission (CERC) reduced the return on equity (RoE) allowed in the tariff to 14% from the previous 16% while finalising the regulations for the renewable energy for the control period FY18-FY20. Earlier regulations allowed 20% pre-tax RoE for the first 10 years and 24% from the 11th year. This translated into a post-tax RoE of nearly 16%, as developers used to avail 80IA benefits.
The reduction in RoE by CERC was driven by a lower risk-free rate while arriving at the cost of equity as per the capital asset pricing model, due to a decline in interest rates. While arriving at the 14% cost of equity, the regulator considered a risk-free rate of 7% and a risk premium of 7%.
According to India Ratings and Research (Ind-Ra), if similar basis were to be incorporated for thermal power plants, the RoE allowed for such plants would decline for the tariff block FY20-FY24. In the past, the regulator kept a higher RoE for renewable power projects at 16% than that allowed for thermal power projects at 15.5% to attract investors.
Considering the trend mentioned above, it is quite possible that the thermal power plant RoE may continue to be 0.5% lower than the renewable power plant RoE, translating to 13.5% from the existing 15.5% allowed by CERC for thermal power plants for the control period FY15-FY19.
Thermal power plant regulations are due for review for the period FY20-FY24. Meanwhile, if the market risk premium or the risk-free rate, which are the two key determinants of cost of equity as per the capital asset pricing model, further decline, the regulated RoE for thermal plants could be lower than 13.5%.
In Ind-Ra's opinion, the lowering of RoE to 13.5% is likely to result in a decline in cash flows from operations. The agency estimates that for a 100MW project built at a cost of INR60 million/MW, the lowering of RoE would translate into a PAT reduction of 13% and a revenue reduction of 4%.
Figure 1: RoE comparison for control periods FY15-FY19 and FY20-FY24
Ind-Ra believes the lower RoE, if allowed, would be the second hit on the profitability of regulated thermal power plants, as CERC regulations had significantly lowered incentives for thermal power plants over FY15-FY19, primarily due to the tightening of operational parameters and the removal of the tax arbitrage.
The reduction in RoE, if allowed for thermal plants to 13.5% from the existing 15.5% will affect the cash flows of plants and consequently the internal rate of return (IRR) expectations of upcoming projects significantly, as thermal power projects are long-term (48-54 months). According to Ind-Ra, a lower RoE would lower the equity IRR, thus impacting the feasibility and viability of such projects. Ind-Ra estimates a decline 150bp and 70bp in equity IRR and project IRR, respectively, if such lowering of RoE happens.
Figure 2: IRR comparison
Therefore, project IRR for a thermal power developer is lower at 8%-9%, marginally higher than the weighted average cost of capital of 7.4% of an 'AAA'-rated public sector unit, assuming a debt/equity of 70:30 (with cost of equity at 12% and cost of debt at 8%).
Ind-Ra expects the lower RoE to affect all plants falling under the regulated regime; however, the impact on newly commissioned plants would be higher, as older plants would have had generated higher RoE in the past while new plants would operate in a period of lower RoE, thus generating lower cash flows over their project life.
Ind-Ra, in a five-part series, will present its analysis on the changes in the business risk faced by regulated thermal power plants that operate under the cost plus return on equity model, which typically lends itself to higher cash flow stability and predictability. In Ind-Ra's opinion, those five risks are broadly classified as i) lowering of the regulated RoE ii) lower fuel availability iii) higher contractual risk iv) lower competitive positioning v) lower financial flexibility.
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